Inheriting an IRA? Understand Your Options

Any inheritance can be complicated, but inherited IRAs—with the many rules that govern their distributions—tend to be especially complex.

When handled with care, however, they can offer substantial long-term advantages, notes Rob Williams, vice president of financial planning at the Schwab Center for Financial Research. In fact, under the right circumstances, you may be able to “stretch” the benefits of an inherited IRA across several decades and multiple generations.

But first, understand your options for an inherited IRA.

When an IRA is set up, the original holder designates a beneficiary (or beneficiaries) to inherit the account. This could be anyone—a spouse, relative, friend—or an entity like a trust. The following options pertain to a sole beneficiary inheriting a traditional IRA. (To learn about an inherited Roth IRA or other retirement account, or the special rules for multiple beneficiaries, read the Schwab Inherited Retirement Account Guide.)

Option 1: Transfer the funds into your own IRA

This option is available only if you inherit the IRA from your spouse.

The rules about subsequent withdrawals are the same as if the account had always belonged to you. For example, if you want to withdraw funds after the transfer but are not 59½ yet, you must pay a 10% early withdrawal penalty. And assuming the money was in a traditional IRA, you must also pay the taxes owed on the distribution—the same as with any traditional IRA.

Option 2: Take a lump sum distribution

This option is open to both spouses and nonspouses of any age. While you may take all the assets in the account as a lump sum without facing a 10% early withdrawal penalty, the withdrawal will typically be taxed. And while that’s not unexpected with a tax-deferred account, bear in mind that taking a lump sum will mean you’ll owe all the taxes at once. This could place you in a higher tax bracket. Importantly, you will also lose out on the potential benefits of any additional subsequent tax-deferred appreciation.

Option 3: Establish an Inherited IRA

Assuming you don’t need all the money at once, you could transfer the funds into an Inherited IRA held in your name. This option potentially enables you to take required minimum distributions (RMDs) based on your life expectancy, while allowing the bulk of the money to potentially continue growing tax free or tax-deferred.

However, this is where it gets complicated. Although your life expectancy may be used to calculate the amount of your RMDs, the initial timing of those RMDs is determined by the age of the deceased account holder and your relationship. Having professional guidance here can really pay off.

“If you don’t calculate your distributions correctly, you could owe a 50% penalty on the RMD amount not taken to the IRS,” Rob warns.

If the original account holder was under 70½, you must begin taking distributions no later than:

December 31 of the year after the original account holder’s death, or

December 31 of the year in which the original account holder would have reached 70½ (option only available to a spouse).

As an alternative, it’s possible to delay taking distributions until the end of the fifth year after the original account holder’s death. But in that case, all funds must be distributed by the end of that fifth year—sometimes called the five-year rule.

If the original account holder was 70½ or older, you must begin taking distributions no later than December 31 of the year after the original account holder’s death. There are also additional considerations in this scenario:

RMDs from the account can be spread out over your life expectancy or the remaining life expectancy of the original account holder, whichever is longer.

If the original account holder didn’t take an RMD for the year he or she died, you need to take that distribution as well—or pay a 50% penalty.

Option 4: “Disclaim” the inherited IRA

By disclaiming, or not accepting, the inheritance, you could allow the assets to pass to an alternate beneficiary named by the original account holder. It would also allow you to avoid tax consequences—while potentially allowing the assets to grow for an even longer period of time (if the alternate beneficiary is younger than you are).

You would need to make this choice within nine months of the original owner’s death and before you take possession of any assets.

The benefits of stretching

Depending on the choices you make when you inherit an IRA, it may be possible to take smaller minimum distributions over time for younger beneficiaries. This so-called stretch option can help preserve assets longer.

“Generally, the longer the money stays in the IRA, the better potential for continued tax-deferred growth,” says Rob. “A stretch IRA is not an account per se, but rather a strategy that allows successive beneficiaries to continue stretching distributions over their life expectancies.”

Of course, your financial institution must allow for the stretch IRA option (as Schwab does). If you’re interested in stretching, pay close attention to the first-distribution dates described above that apply to your particular situation. If you open an Inherited IRA and don’t take your first distribution by that date, the account defaults to the five-year rule.

What you can do next

If you’re inheriting an IRA, careful planning is required. Guidance from a tax professional could help you make the best possible choices.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

The investment and tax strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment or tax strategy for his or her own particular situation before making any decision. Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

(1218-8CTH)

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